Russia’s Great Deceleration

Russia’s fortune and growth prospects remain tied to its most important economic partners in the Euro area and its main export products: oil and gas. In the last decade Russia grew at around 6 percent (if we exclude the crisis year of 2009 - 4.7 percent on average otherwise).

This high growth was driven by high commodity prices, but it also translated into the non-tradables. Russians enjoyed a higher standard of living and consumed more. The economy still looked strong in 2012 when the country grew at 3.4 percent, especially when compared to Europe, the US and Japan, but also vis-à-vis emerging economies such as Brazil and Turkey. Unemployment dropped to record lows and real wages grew, with poverty decreasing dramatically in recent years.

In the past, given the buoyant oil revenues, Russia followed a pro-cyclical growth model of stimulating domestic demand, partly through public investment projects and partly through increasing public wages and other public income sources such as pensions.

If the prices of oil and gas were to drop in the near future, Russia’s growth model might be in need of urgent adjustment.

At present, growth in Russia is experiencing great headwinds of external and domestic nature, which could jeopardize its medium-term growth outlook. Growth slowed to 1.4 percent in the first half (H1) of 2013, compared to 4.5 percent in H1 2012. One reason for this was sluggish external demand. Falling exports and lower resource prices reduced the trade surplus to US$91.6 billion (9.1 percent of GDP) in H1 2013, from US$108.3 billion (11.5 percent of GDP) in H1 2012. For most of the first half of 2013 oil prices were around US$ 100/bbl.

Lower oil prices in H1 were immediately translated into lower federal oil revenues (dropping from 11.2 percent of GDP to 9.8 percent). The Federal Government reacted and exercised higher control over budget spending during the first seven months of 2013. Federal expenditures declined in January-July 2013 to 19.1 percent of GDP from 20.9 percent of GDP during the same period in 2012.

The World Bank’s recent Russia Economic Report projects that Russia’s growth will recover in 2014 to around 3 percent, with oil prices at around US$105 /bbl. However, with the budget situation in the US and the withdrawal of the monetary stimulus becoming more certain, the prospect of a sustained recovery is unsure and could contribute to lower global trade and growth impetus. Lower commodity prices are not inconceivable in this scenario. What would this mean for Russia’s outlook? We have developed an alternative scenario with a decrease in oil prices to US$80 /bbl, which illustrates the downside risks to our own forecast. The Ruble would depreciate by about 20 percent, the current account surplus would shrink in nominal terms and net capital outflows would double to -4.4 percent of GDP. The economy would contract by 2 percent and the budget would fall into deficit.

Table 1: Growth outlook with one time oil price shock in 2014

But, perhaps there is even more to worry about with respect to the health of the Russian economy and its medium-term growth prospects. In addition to Russia’s continued high external vulnerability to oil prices, and the risk of high volatility in external demand, we believe the economy will be facing binding constraints to domestic demand growth. The pace of future expansion will be held back by the economy operating near its full capacity. Recently, one could observe very high capacity utilization – over 80 percent and near pre-crisis levels when the economy was growing at 8 percent annually- and Russia had record low unemployment rates. Also, in H1 2013 non-tradable sector growth slowed dramatically. We see little dynamism in the manufacturing sector, which suffered from the high volatility of Russia’s growth in the past and also from the lack of competition. Unless a growth model which also includes supply-side constraint to growth in Russia will be more squarely implemented, target growth rates of 6-7 percent might be an elusive goal.

With this blog I hope to start a discussion about the weaknesses of the past growth model in Russia and what could be done to improve it. I look forward to reading your comments and views.

Comments

This is a very interesting piece on Russian economy and its challenges. I draw out one important fact – high dependency on one product for exports/foreign exchange earnings - oil. In this regards, Russia needs to diversify its economy. An issue most developing countries are struggling with. It will be interesting to see how you assist Russia in this discussion and developing a strategy for diversification.

Thank you for your comment Lucy. Diversification of an economy -such as Russia- is indeed an important aspect and here we would suggest to look at what were key factors that prevented more broad-based growth on the micro or firm-level in the past. We believe the issue is less about picking through heavy-handed industrial policy the "right" sectors to diversify an economy. It is rather about creating the right conditions for the market that would allow new and innovative firms to emerge and then to grow to their full potential. Our analysis is showing that for Russia the problem is not that new and more efficient firms do not emerge, they do, but once a shock hits the economy (and we show that shocks are longer and more severe in the Russian economy, related to the high reliance on a few commodities), these firms are less likely to survive. Our analysis also shows that low competition is a significant variable in increasing the risk of these new and more productive firms not being able to survive. This ultimately limits the sustainability of diversification in Russia. Creating the right conditions for diversification, especially sustainability of diversification, should be part of a diversification strategy.

Thank you for sharing vital information on poverty and inequality. This is a great contribution to citizen awareness and engagement in the national, regional and global development process
I shall share with friends in the ME, especially Iran. tks again
Baquer Namazi

Thank you for your analysis. I had a question regarding your bad case scneario of an oil price slump to $80/b in 2014. IMF in its Article IV consultation is actually looking at an adverse scenario of $60/b for 2014-2018 and predicts a GDP downfall of -1% in 2014 and then a recovery of the growth rate to 2% by 2018. This also assumes that the oil reserve fund is used in 2014 to prop the economy.
I am curious to get your comments on this anaylses. What are your assumptions regarding the use of oil reserve fund when the oil price drop to $80/b and GDP falls to -2%. Ann

Thank you for the comment on our analysis. Good questions. In our model we do not project a fiscal response from Government in form of using the reserve fund. If we assume the same Government budget as in base case, the consolidated budget deficit would reach in the oil price drop scenario to -1.3 percent of GDP in 2014. There are different ways Government could react, including adjusting expenditures as much as possible, increasing the debt level or using parts of the oil reserve fund. If we assume that all would be covered by oil reserve fund resources, the effect would be easy to calculate: For the base case scenario the reserve fund was 4.8 percent of GDP at end-2013 and 4.9 percent of GDP at end-2014.